My new book quantifies fear and greed in money managers, investors and traders. We’ve developed a number of quantified strategies around those high probability trading opportunities. The edges in the book are high – a number of the strategies have been correct well over 90% of the time in predicting prices in stocks and ETFs. As you know, fear and greed is inherent in the market place and when it occurs, substantial opportunities exist for you.

Today is Part 2 of our 10 part series on improving your trading. Today we’ll look at Position Sizing.

Position Sizing is a large topic. Entire books have been written on the subject, yet as of today in my opinion, a definitive book of this subject has yet to be written.

With that said, let’s look at some simple concepts to make sure you have a base for your understanding and then we’ll go a bit deeper.

1. Shares Versus Dollars When Putting on a Position

This one is obvious to most traders with any experience so it’s mostly directed to newer traders who are reading this lesson. Positions should not be bought in “shares”, they should be bought in “dollars”. I see people on trading boards discussing they’re 100 share buyers or 1000 share buyers. And they get into the habit (the bad habit) of buying the same number of shares no matter what the price is or what its volatility or beta is.

Let’s assume someone has a $200,000 trading account. Let’s take two stocks and assume they have the same volatility. One stock trades for $10 a share and the other trades for $25 a share. The beginning trader often treats them equally. They’ll buy 1000 share because they’re a “1000 share” trader.

The $10 stock will cost them $10,000 which is 5% of their portfolio. The $25 will cost them $25,000 which is 12.5% of their portfolio.

As much as this should be intuitive and obvious, somehow beginning traders get into the habit of fixating on round-number shares and after doing this for a while it becomes a built-in habit. Some habits are good and some are not so-good. This one falls into the latter category.

At a minimum, one should buy their positions as a percentage of their dollar portfolio, not as a fixed number of shares.

2. Position Size as a Percentage of Your Portfolio

This is where things begin to get interesting and everyone has an opinion of this. What percentage of my portfolio should I place into the position to optimize my returns?

Books by very smart people have been written on this topic and when you read their reviews, or read about their concepts online, the discussions range from heated to all-out verbal war.

Some people keep this concept very general (and one could argue too general). Never risk more than X% on a trade. Or never put more than Y% into a position. This is a good start if the X% or Y% makes sense.

Then it goes deeper and this is where the real fun begins. You’ll read about advanced concepts such as Kelly Criterion which is a formula used to determine the optimal “bet size” of a position. Kelly has been and is still applied by a number of the most successful hedge funds in the world. Ed Thorp, the creator of card counting in blackjack, and who arguably was the greatest performing hedge fund manager in history, is one the biggest proponents of Kelly. You can read about the history of Kelly and Ed Thorp in William Poundstone’s brilliant book “Fortunes Formula”.

Before you believe that you’ve just been given the holy grail of money management because there’s been so much reported success applying Kelly, spend some time with the Kelly formula (you can find it online).

If you have a high probability trading strategy with good risk/reward characteristics you can easily find yourself putting 60% or more of your portfolio into a position. Kelly’s main attribute is to optimize returns and it’s much too aggressive for the overwhelming majority of people who understand it. In fact, I attended a conference a few years ago that Ed Thorp spoke at and he said Kelly was too aggressive even for him (he said he often used partial Kelly). Some traders use 1/2 Kelly or 1/4 Kelly and even these reduced levels are still too aggressive for most traders.

This is an endless debate as to what is optimal position sizing. If you’re going to take your trading seriously though, it’s a topic that’s worth studying to ultimately bring you to the level of risk you’re willing to assume in order to achieve your goals.

3. Volatility and Beta

Let’s focus on the movement of the security and at least for today, primarily focus on historical volatility.

Many traders don’t fully account for a security’s volatility and they should. JNJ trades very differently than NVDA or OSTK. The historical volatility of JNJ is significantly lower than NVDA and OSTK. JNJ usually doesn’t rise of fall 25% within a few months. NVDA and OSTK regularly do.

One of the ways to position size is to take a security’s 100-day historical volatility or if you want to look longer its 256-day (one trading year) historical volatility. Then position size by equaling out the volatility. Therefore a possible way to position size is if a security has a 100-day historical volatility of 50% one would buy half the amount of a security versus one that has a historical volatility of 25%. This same can be done using beta (this is common), and there are many additional ways to do this. The main goal of each is to get you to the point of taking on an equal amount of volatility per position.

4. Correlation Risk

This one trips up traders all the time.

Let’s say one has a simple trading system. Buy any stock that is extremely oversold (use any oversold measurement you like). Let’s assume you decided to keep things simple, and not apply Kelly or Volatility Balancing – it’s going to be dollar size. You have $100,000 in the trading account and you’re going to buy $10,000 per position.

This sounds simple enough. And it is until OPEC announces something that crashes oil prices. With falling oil prices comes falling oil and oil-related stocks which usually go into a free-fall. Over the next few days there are dozens of buy signals triggering from your strategy and all are oil- and energy-related.

So what do you have? You have one big oil fund, and potentially one with some extremely volatilie holdings because when oil prices drop big, the most volatile, and usually the most debt-heavy companies drop first and the most.

I had this happen to me many years ago. A quiet steady portfolio had suddenly become a high volatility oil fund within a 48 hour period of time. As oil prices went over the next days this once conservatively-managed trading portfolio went too. Fortunately, oil stabilized and got a quick bounce and the portfolio was able to rapidly decrease it’s exposure to oil prices. Lesson learned.

Correlation matter and one can lessen the correlation risk by tracking how correlated positions are (if you’re short-term trading, use a shorter date-correlation reading, not one that looks back 1-2 years). If you’re not at that level yet, a basic method that states one is not going to allow more than X% of the portfolio to be in a sector or related sectors is a good place to start.

Correlations risk wipes out the best – it happened to Long-Term Capital in the late 1990’s and it happened to a number of very large firms in 2008. Spending time combining position sizing and correlation risk is time well-spent.

The above is an overview on position sizing and some of the risks to look out for in order to lower risk and potentially increase gains. Additional knowledge can be found in books on the topics above and also in one of my favorite books “Trading Risk” by Ken Grant who oversaw the risk teams for three major hedge funds during his career.

In the next issue of the Connors Research Traders Journal we’ll look at part 3 of this series “Lower Your Risk.”

About Larry Connors

Larry Connors has over 30 years in the financial markets industry. His opinions have been featured at the Wall Street Journal, Bloomberg, Dow Jones, & many others. For over 15 years, Larry Connors and now Connors Research has provided the highest-quality, data-driven research on trading for individual investors, hedge funds, proprietary trading firms, and bank trading desks around the world.

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